Monday, November 1, 2010

Why Some People Should Not Run Central Banks

Sorry for beating a dead horse here, but these two posts were hard to resist. Krugman posts this piece on his blog. In particular, he says:

In particular, an individual businessman, no matter how brilliant, never has to worry about the fact that total income equals total spending, so that if some people spend less, either someone else must spend more, or aggregate income must fall.

This is why we have a field called macroeconomics.

Actually, this is why we have national income accounting.

Next he posts this piece. Krugman is going to tell us what he would do if he were in Bernanke's shoes. First he would commit to a price level target that implies average inflation of 5% per year. Not unexpectedly, he wants more inflation than Bernanke does, but of course we have no good reason to prefer 2% to 5%, as far as I can tell. Now, the key thing is that he doesn't inform us about how he hopes to achieve this. He says:

The sad truth, of course, is that the chance of actually getting anything like this are no better than those of getting an adequate fiscal stimulus — at least for now. QE as currently contemplated is mild mitigation at best. What one has to hope is that as the reality that we’re in a liquidity trap sinks in...

It's not clear what is "currently contemplated," but of course we will find out in a couple of days. In any case, Krugman doesn't tell us what he would actually do to get the 5% inflation. People at the Fed of course know about liquidity traps, which is why they are talking about purchases of long Treasuries, rather than purchases of T-bills. Does Krugman think that more than what is "currently contemplated" would achieve the result he wants? If so, how much? Please enlighten us.

No, he is very smart. I find him interesting, which is why I write about him. The first part of his argument, in favor of price level targeting, is just fine, though if he were stepping into Bernanke's shoes, he should not be advocating 5% inflation when Bernanke has been talking about 2% for months. I think the reason he is not being specific about how to hit the target is that in the future he wants to be able to look back and say that he was right.

I added a comment late to your October 15th post, so perhaps you didn't see it. It was in response to your I don't know if and why higher or lower inflation at least within single digits matters statement that you make again here. So here it is:

"Bernanke cannot really tell us why the inflation rate should not be -1%, 0%, 4%, or even 10%, rather than 2%, and neither can I."

Balance Sheet Repair!

Higher inflation would do wonders via balance sheet repair, to consumers, businesses (except finance, but that includes some of the worst, slimiest elements), and the government. This is a huge NET benefit.

2) It makes real wages more flexible -- and there is great evidence for a lot of inflexibility with nominal wage cuts.

3) It gives the Fed a lot more ammo in cutting real short term rates.

These benefits are far from trivial.

Inflation that's higher in magnitude than say 4%, tends to be more volatile, and just psychologically people don't like it, and it makes it harder to plan (yes, despite the assumptions that so many freshwater economists like to take literally, humans aren't super fast calculating robots). Also, the deflation rate is the minimum real interest rate -- you might not want that rate at like 10% or more.

While going to a 5% inflation rate would be good for debtors, have you thought about the other problem? Currently, lenders (particularly mortgage lenders) are committing to long term loans with very low nominal interest rates. If you are borrowing short and lending long (as banks certainly are known for doing), then when a 5% inflation rate ultimately necessitates increases in short rates, there is a balance sheet disrepair going on. On (3), this is not clear - depends on the costs of long-run inflation, costs of inflation variability, and what you think the short-run nonneutralities of money are about.

Regarding the balance sheet problems you and Richard discuss, David Beckworth argues that QE2 could improve them through other channels: http://macromarketmusings.blogspot.com/2010/11/how-would-qe-ii-help.html

I think the balance sheet benefits to families and the government far outweigh the costs to banks, and it's a redistribution of income from a group consisting largely of rich slimebags who made their money unethically to struggling families who were their victims.

Plus, the new finance bill gives much stronger resolution authority to the government for failing banks. Putting it to the test if necessary will show if it's strong enough.

But back to a previous point, ignorance is a very serious problem, and if you ignore it, or don't like fully acknowledging it in your decisions, in your interpretations from models to reality, then your decisions will be far worse. You have to think about effects on the electorate. I hope tonight, and the way the Republicans campaigned, how well it worked for them, impacted your thinking on this. See here for example:

Some of the best ways to advance the economy are political. The big one is ending the filibuster so that try-and-see, often a tremendous tonic to ignorance, lying, and misleading, can be (and could have been by the Democrats) really unleashed. For more on this see:

How about the losses that families would have in pension plans invested in 'safe' assets suchs as Treasuries?

How about the higher borrowing costs to the government after moving to 5% inflation? Why lenders won't ask for a significantly higher risk premium? Lenders may update their perceptions about how costly it is for the government to increase inflation. If the government moves to a 5% inflation now, what would prevent it from increasing inflation to 10% or 15% in the future?

I couldn't make much sense out of Beckworth. It certainly is true, though, that QE2 is all about balance sheets. Make the assets on the Fed's balance sheet longer maturity and less liquid, and make the assets on private balance sheets shorter maturity and more liquid. What happens? What is critical is whether the Fed has some advantage in intermediating long-maturity assets relative to the private sector. What the FOMC can agree on, I think, is that inflation is too low relative to their target. Potentially QE2 does the trick, but clearly no one has any idea whether it will. My worry is that the Fed could be committing itself in a way that keeps it from controlling inflation if we get too much of it. One of the potential costs is stress on the banking system. Now, we know which banks are going to be stressed - Bank of America and Citigroup in particular. On the one hand, it's hard to be sympathetic to the plight of those dopes, and resolution might work in the event that is necessary. On the other hand but I'm not sure we need to reopen the moral-hazard-bank-regulation can of worms so soon after the recent crisis.